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What could happen to the global economy if US defaults

Some private economists see devastating effects, such as stock markets plunging. But other economists don't envision such a scenario, suggesting that the Fed, for example, may step in.

By Ron SchererStaff writer / July 26, 2011

President Obama speaks in a prime-time address to the nation from the East Room of the White House in Washington, on July 25, as polarized lawmakers failed to rally behind a plan to avert a disastrous debt default perhaps just one week away.

Jim Watson/Reuters

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If the US were to default on its debt or have its bonds downgraded, the ripple effect would reach the global economy.

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That’s the view of Christine Lagarde, the new managing director of the International Monetary Fund (IMF), who emphasized that the US should resolve the debt-ceiling issue quickly.

“Frankly, to have a default, to have a serious downgrading of the United States’ signature would be a very, very serious event,” said Ms. Lagarde at a meeting of the Council on Foreign Relations in New York. “Not for the United States alone, but for the global economy at large because the consequences would be far-reaching. It would not stop at the frontiers of the United States; it would go beyond.”

If the US were to default on the interest on its bonds, private economists say, it would cause banks around the world to write down the value of their enormous holdings of US Treasury securities. At the same time, stock markets around the world would probably plunge.

“That would have a devastating effect,” says Jay Bryson, international economist at Wells Fargo Economics Group in Charlotte, N.C.

If banks were to write down the value of their bonds, they would have to raise capital quickly or shutter their doors, Mr. Bryson says. “Their capital base would shrink, and when that happens, they are less likely to make loans,” he says. “It would spill over very quickly to the real economy.”

However, not all economists envision a doomsday-like scenario.

Nariman Behravesh, chief economist for IHS Global Insight in Lexington, Mass., says the Federal Reserve would step in to stabilize the financial markets.

“I suspect the Fed already has contingency plans for this problem,” Mr. Behravesh says. “It does not necessarily have to be a disaster.”

The US Treasury would continue to pay the interest on US debt, he says. However, he estimates that the government is spending 40 percent more than it’s taking in. This means the government would have to stop paying other bills coming due.

“We would have to slash paying for Medicare, issuing Social Security checks. That would kill the economy,” Behravesh predicts.

On Wall Street on Tuesday, investors continued to shy away from the stock market. The Dow Jones Industrial Average was off about 85 points, and the price of gold ticked up by some $7 an ounce to about $1,619.

Even if the debt ceiling is raised and spending cut by the Aug. 2 deadline, an economic spillover could still happen.

Although Lagarde didn’t comment on any of the plans under discussion in Washington, she did say that IMF studies have found a short-term negative economic impact from shrinking budget deficits. The current Republican and Democratic proposals have the budget deficits shrinking by $1 trillion to $4 trillion over 10 years.

“To be precise, our studies show that a reduction of one percentage point on the deficit entails in many instances 0.5 percent off the growth number,” she enumerated. That’s why, she said, the IMF recommends any budget cutting take place at a time when the economy is growing.

Bahravesh, for one, says Congress should postpone major spending reductions for at three to four years. “It’s a bit of a balancing act. We think you want to backload it versus starting it next year,” he says.

He points to Britain as an example of an economy that is suffering from large cuts in government spending. On Tuesday, Britain reported that second-quarter gross domestic product rose by only 0.2 percent compared with the prior quarter. “The UK’s economy is dead in the water,” he says. “That’s not what the US wants.”

Once an economy adjusts to a smaller government footprint, the IHS economist says, the private sector might become more robust. The payoff for the economy takes five to 10 years, he says.

If the rating agencies downgrade US bonds, it might have a negative impact on some money-market mutual funds and insurance companies whose standards require them to invest in the highest-rated bonds. But it might not be disastrous, Bahravesh says.

“What are the alternatives?” he asks. “Where do money-market funds and insurance companies go? Do they buy Chinese bonds or German bonds? There are no good alternatives.”

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